The way central banks manage their foreign reserve assets has evolved over the past decades. One
major trend is managing reserves in two or more tranches—liquidity tranche and investment
tranche—especially for those with adequate reserves. Incorporating reserve tranching, we have
developed in this paper a central bank’s reserve portfolio choice model to analyze the determinants of
the currency composition of reserves. In particular, we adopt the classical mean-variance framework
for the investment tranche and the asset-liability framework for the liquidity tranche. Building on
these frameworks, the roles of currency compositions in imports invoicing and short-term external
debt, and risk and returns of reserve currencies can be quantified by our structural model—a key
contribution of our paper given the absence of structural models in the literature. Finally, we estimate
the potential paths of the share of RMB in reserves under different scenarios to shed light on its status
as an international currency.
